McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 1 1 Fundamentals of Investment Management Hirt Block 1 Basic Valuation Concepts 1. Dividend valuation models Constant growth Non-constant growth Finite/infinite holding period 2. Earnings valuation models P/E Ratio based model Dividend and Earnings model 3. Other Valuation models Price to Sales Price to Dividends Price to Earnings Price to Cash flow Price to Book Value

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 2 2 Fundamentals of Investment Management Hirt Block 2 The value of a share of stock is equal to the present value of an expected stream of future dividends. P0=P0= D 1 (1+K e ) 1 D 2 (1+K e ) 2 + D 3 (1+K e ) 3 + D n (1+K e ) n Where P 0 = Present value of the stock price D i = Dividend for each year K e = Required rate of return (discount rate) Model assumes that the investor can determine the dividend for each period and the required rate of return. 1. General Dividend Models

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 3 3 Fundamentals of Investment Management Hirt Block 3 For extremely long time (infinite holding period) periods, this formula reduces to if following conditions are met. 1. g is constant 2. K e > g Constant Growth Model P0=P0= D 0 (1+g) 3 (1+K e ) 3 + D 0 (1+g) 2 (1+K e ) 2 + D 0 (1+g) n (1+K e ) n D 0 (1+g) 1 (1+K e ) 1 P0=P0= D 1 (K e - g)

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 4 4 Fundamentals of Investment Management Hirt Block 4 Required Return K e = Required rate of return R F = Risk-free rate b = Beta Coefficient K M = Expected return for common stocks in the market (K M - R F ) = Equity risk premium (ERP)

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 5 5 Fundamentals of Investment Management Hirt Block 5

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 6 6 Fundamentals of Investment Management Hirt Block 6 A Nonconstant Growth Model 1. Divide time period into intervals of constant dividend growth 2. Calculate the dividend at the beginning of each period 3. Calculate the Present Value of each interval of constant growth 4. Price = Sum of the PVs

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 7 7 Fundamentals of Investment Management Hirt Block 7 Figure 7-1. JAYCAR Growth Pattern. Dividends per share 20% (years 1-10) 8% (years 11 to infinity)

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 8 8 Fundamentals of Investment Management Hirt Block 8 Non-constant growth illustration P 10 = D 11 / (K e - g) Dividend Year 11 = Div 10 x (1+ growth rate) = 5.15 ( 1.08) = 5.56 P 10 = 5.56 / (12% - 8% ) = 5.56 /.04 = $139 Discount to Present: $139 /.322 = $44.76 P 0 = $12.42 Growth pattern first ten years JAYCAR's + $44.76= $57.18

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 9 9 Fundamentals of Investment Management Hirt Block 9 2. Combined Earnings and Dividend Model The value of common stock can be viewed as a dividend stream plus a market price at the end of the dividend stream. Earnings-per-share and dividends-per-share are estimated for some period. Ending stock price estimated by using long- term PE ratio. Stock Price = (Present value of dividend flow) + Present value of stock price

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 10 Fundamentals of Investment Management Hirt Block 10 Price Earnings Ratio It indicates the price that investors are willing to pay for a firm’s earnings. Published P/E ratios based on today’s price divided by the latest 12-month earnings. P/E ratios can be a proxy for risk. The higher the P/E ratio relative to the market P/E ratio, the higher the risk.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 11 Fundamentals of Investment Management Hirt Block 11 Price Earnings Ratio P/E ratios vary across industries. P/E ratios are also influenced by the political and economic conditions, management abilities and quality of earnings.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 12 Fundamentals of Investment Management Hirt Block 12

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 13 Fundamentals of Investment Management Hirt Block 13

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 14 Fundamentals of Investment Management Hirt Block 14 Calculating Value based on relative P/E

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 15 Fundamentals of Investment Management Hirt Block 15